Financial Markets
IN THE FINANCIAL markets, people and organizations needing or wanting to raise funds or capital are brought together with people or organization who has spare or surplus funds (savers ). FINANCIAL markets - There are many & of different types. Each one dealing with a different type of financial asset, serving a different set of customers, or operating in a different part of the country.
Financial markets facilitate: The raising of capital (in the capital markets) The transfer of risk (in the derivatives market); and International trade (in the currency market i.e. Foreign Exchange market).
They are used to match those who want capital to those who have it.
Financial Market
There are various markets - Distinctions between them are not always clear and may not be as important except for as a point of reference and to develop a sense as to the big differences among various types of markets. Money Markets : A Financial Market in which funds are borrowed or loaned for short period of time i.e. it is a market in which highly liquid debt securities ( treasury notes & bills, corporate commercial papers ) with short maturity ( less than a year ) are traded.
Capital Markets : A market in which longer term debt ( Bonds with longer than one year maturity ) and corporate stocks are traded.
Financial Market
Primary Markets : A primary market is one in which companies raise new capital by selling newly issued securities. The corporation selling the new issue receives the proceeds from the sale in a primary market transaction. Secondary markets - Markets in which existing, previously issued and already outstanding securities are traded among investors. Corporation whose securities are being traded is not involved in a secondary market transaction and therefore does not receive any funds from such a sale. Private Markets - Markets in which transactions are carried out between the two parties. Bank loans and private placement of debt with insurance companies are examples of private market activity. Transactions structures are often customized, i.e. structured in a manner that appeal to both parties. Private market securities are less liquid.
Financial Market
Spot Market - A commodities or securities market in which goods are sold for cash and delivered immediately.
Contracts bought and sold on these markets are immediately effective or a futures transaction for which commodities can be reasonably expected to be delivered in one month or less.
Though these goods may be bought and sold at spot prices, the goods in question are traded on a forward physical market. The spot market is also called the "cash market" or "physical market", because prices are settled in cash on the spot at current market prices, as opposed to forward price. Crude oil is an example of a future that is sold at spot prices but its physical delivery occurs in one month or less.
Financial Market
Futures Market - An auction market in which participants buy and sell commodity/future contracts for delivery on a specified future date. Trading is carried on through open yelling and hand signals in a trading pit. Forward Markets - Forward contracts are personalized between parties and therefore not frequently traded on exchanges. The forward market is a general term used to refer to the informal market in which these contracts are entered and exited.
Financial Market
Over the Counter ("OTC") money market products such as loans / deposits. These products are based upon borrowing or lending. They are known as "over the counter" because each trade is an individual contract between the two counterparties making the trade.
They are neither negotiable nor securitized. Hence if I lend your company money, I cannot trade that loan contract to someone else without your prior consent. Additionally if you default, I will not get paid until holders of your company's debt securities are repaid in full. I will however, be paid in full before the equity holders see a penny.
Financial Instruments
Financial instruments are legal agreements (Real or virtual) having some sort of monetary value and can be either cash instruments or derivative instrument.
Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer.
Derivative instruments are financial instruments which derive their value from some other financial instrument or variable. They can be divided into exchange traded derivatives and over-the counter (OTC) derivatives.
Financial instruments can be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt (long term/ short term) based (reflecting a loan the investor has made to the issuing entity).
Financial Instruments
Equities: or shares (termed "stocks" in the US). Stocks are ownership shares in a company.
Mutual funds: Investor's money is pooled together, generally to purchase stocks and bonds. Investors participate in the mutual fund by purchasing shares of the entire pool of assets, thus diversifying their investment. The pooled assets are invested by professional managers who buy and sell securities on behalf of the investors.
A closed-end fund: has a fixed number of shares outstanding and is traded just like other stocks on an exchange or over the counter. The open-end funds: sell and redeem shares at any time directly to shareholders. Sales and redemption prices of open-end funds are determined based on the fund's net asset value; closed-end funds may trade a discount (usually) or premium to net asset value. Bonds: Bonds are medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra-national organizations such as the World Bank, and companies. Negotiable means that they may be freely traded without reference to the issuer of the security. There are various different varieties of Bond e.g., Eurobonds, domestic bonds, fixed interest / floating rate notes, etc.
Gold Standard
From 1876 to 1913 each currency was convertible to gold at a specified rate & thus exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold. Suspended during World War-I during 1914. Revived again in 1920 but abandoned due to banking panic in USA & Europe during Great Depression. In 1930s some countries pegged their currencies to the dollar or pound, but due to instability in FE market, system did not work.
It is a 24-hour market
The business day opens in Wellington, New Zealand, followed by Sydney, Tokyo, Hong Kong and Singapore. A few hours later, trading begins in Bahrain. Late in the Tokyo day, markets open in Europe. In the early afternoon in Europe, markets open in the United States. In the mid to late afternoon in New York, markets open in the Asia-Pacific area. Most of the activity takes place when European markets are open.
Source: BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007.
Market participants include international banks, their customers, non-bank dealers, FX brokers, Note: Data is from 2007. and central banks
Participants of FE Market
1. Large Commercial banks (through combisters or dealers) operating either at retail level for individual exporters or corporations or at wholesale level in the inter-bank market (known as Authorised Dealer) act as Market Maker. Central banks of various countries intervene in order to maintain or influence the exchange rate of their currencies within a certain range (execution of govt. order). Individual Brokers/ Corporations Bank dealers often use brokers to stay anonymous since the identity of banks can influence short-term quotes.
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Market Makers
A market maker for a currency is a dealer who regularly quotes the rates at which he is willing to buy and to sell that currency. During normal hours, he creates a twosided market for its customers. He is willing (within reason) to both buy and sell at the rates he quotes. He makes a profit from the spread; that is the difference between the selling and buying rates.
Central Banks
Central Banks intervene in the foreign exchange market to influence the value of their currency. Many central banks serve as the primary banker for their government and for other public enterprises. Some central banks (for example, the Federal Reserve Bank of New York) act as agent for other central banks. Some central banks actively manage their foreign exchange reserves.
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Depreciation Factors
Factors that cause a currency to depreciate:
A rapid growth of income (relative to trading partners) that stimulates imports relative to exports. A higher rate of inflation than one's trading partners. A reduction in domestic real interest rates (relative to rates abroad).
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Now, owing to an emergency, you can not take the trip & thus reconvert $ to Rs. = (25,302.875 X 39.4106) =Rs.9,97,201.5 Due to bid-ask spread, you have Rs.2798.5 less than what you have started. Single rate mentioned in some news paper quotes is Mid-Rate i.e. the arithmetic mean of Bid & Ask rate.
Cross Rate =
The cross rate between Citibank & Barclays Bank is: ($1.4443/ ) ($0.9045/ ) = 1.5968/
But this cross rate is not the same as Dresdner Banks quotation thus opportunity exists to profit from arbitrage among three markets - Triangular Arbitrage.
Triangular Arbitragecontd.
A market trader with $1,000,000 can sell that sum spot to Barclays Bank for ($1,000,000 $1.4443/) = 692,377. Simultaneously, these can be sold to Dresdner Bank for (692,377 X 1.6200/ ) = 1,121,651; Now, the trader can sell these euros to Citibank for $: (1,121,651 X $ 0.9045/ ) = $1,014,533. The profit on one such turn is a risk free $14,533. Such Triangular Arbitrage will continue till exchange rate equilibrium is re-established i.e. calculated cross rate equals the actual quotation (less any tiny margin for transaction cost).
Types of Contracts
Spot contracts -- a price and quantity are agreed upon. The two currencies are typically exchanged two business days later. Forward contracts -- a fixed price contract made today for delivery of a certain amount of a currency at a specified future date. The specified date is the settlement date and the agreed price is the forward rate. More precisely, the two currencies are exchanged on an agreed upon date which is a certain number of days or months after the spot date. Thus, a three-month forward contract is conventionally settled in three months plus two days. Typically, no money changes hands at the time the contract is written
To protect the BAAC from exchange rate fluctuations, Frank Dollar arranged to purchase 600 million yen forward from Mega Bank. The two-month forward price was 120.00 yen/dollar. In two months and two days, Dollar paid 5 million dollars and received 600 million yen.
At time zero: All of the details of the contract were worked out At time zero plus two months and two days: The exchange is carried out.
In this instance, the SF is 22.07% stronger at the ending rate. Holders of US $ receivables will receive 22.07% more $ - but those who owe Swiss francs will have to pay 22.07% more to buy them.
By both methods of calculation, the Swiss Franc increased by 22.07% in value relative to the Dollar.
For any quotation (A/B), a negative answer would indicate that currency B is at Forward Premium vis--vis Currency A where as a positive answer would imply that B is at a forward discount against A.
Swap Transaction
While banks quote & do outright forward deals with their non-bank customers, the inter-bank market forwards are done in the form of swaps. Swap is a double-leg deal, in which one buys spot currency A selling currency B & simultaneously sells forward currency A buying currency B.
Since there will be a forward discount or premium on A vis--vis b, the rate applicable to the forward leg of the swap will differ from that applicable to the spot leg. The difference between the two is Swap Margin corresponding to forward premium or discount.
A pair of Swap points to be added or subtracted from spot rate to arrive at the implied forward rate.
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Non-Deliverable Forward
It is available with some currencies with restricted capital accounts. Here the full amounts of two currencies are not exchanged as contract maturity; only the difference between the contract rate & the spot rate at maturity is settled in a convertible currency such as US $.
Thus if a firm enters into a 90-day non-deliverable forward contract to buy US $5,00,000 against the rupee @ Rs.39.26; at maturity the spot rate is Rs. 38.86. The firm must pay the bank US $ equivalent (at the spot rate) of Rs.{500000 X (39.26 38.86)} i.e. Rs.2,00,000 The payment would be US $(2,00,000 / 38.86)= $5146.68
This product allows foreign investors to hedge their investments in the local currency without actual outflow of foreign exchange.
Short-Date Contracts
Usually, the normal value date for a spot transaction is 2 business days ahead. But it is possible to deal for shorter maturities i.e. value same day cash- or value next day tom or tomorrow in currencies whose time zone permits the transaction to be processed.
For example, it is possible to do a /$ deal for delivery same day because the 5-6 hours delay between New York & London allows instructions to be transmitted & processed in New York.
Short date transactions are those in which value date is before the spot value date.
Short-Date Contracts..
In the FE markets, one-day swaps are quoted between today & tomorrow (Overnight or O/N), tomorrow & the next day (tom/next or T/N) and Spot date & the next day (spot/next or S/N). Note that the T/N swap is between tomorrow & the spot date these swap rates are governed by the relevant interest rate differentials for one day borrowings these are used for rolling over maturing positions
Rule for calculating outrights before spot date Reverse the Swap margins & then follow the usual rule (i.e. add if low/high subtract if high/low).
it may be an option forward where delivery may be during a specified week or fortnight, in any case not exceeding one calendar month.
Market follows a system of direct quote given as rupee per unit (or per 100 units) of foreign currency, with the bid-rate referring to market-maker buying the foreign currency & the offer rate being market makers rate for selling the foreign currency.